Do You Know Where Your Securities Are Tonight?

In order for someone to short a security (sell stock that isn’t theirs) they first need to “borrow” the shares.But who really wants to loan his or her securities to someone that is going to bet against them? After all, short sellers put pressure on the price of your stock, say bad things about your company on message boards, and generally hope that your investment will decline in value, so they can pay you back in “worth-less” securities. Knowing this, no intelligent investor would ever lend their securities to a short seller – so your brokerage firm does it for you.

What? My brokerage firm is loaning my securities to short sellers to bet against me without my knowledge? Yes, if you have a margin account with your brokerage firm you have signed a “hypothecation” agreement allowing that firm to put your shares up as collateral at a bank so they can borrow the funds they loan to you. Nothing wrong with that you say – but buried in the agreement is the blanket right for that brokerage firm to do just about anything it wishes with your securities as long as your loan is outstanding. This means if you own shares in a young biotech company that you are very excited about your brokerage firm can loan those shares (your shares) to anyone that wants to sell those securities short. If the short sellers can dump enough shares, and drive the price lower, it just might ruin that company’s ability to raise capital and grow its business. In other words short sellers work to destroy the value of the company that you thought was so promising – and they do it with your shares! Sorry about that.

In the old days most of us kept our securities under the mattress or in a safe deposit box and we would never think of loaning them to someone that deliberately set out to bet against us. But in the era of the electronic back office few of us ever get to see our certificates, our ownership rights are obfuscated, and brokerage firms use our certificates to earn extra fees by loaning them to short sellers. Bad things happen in the middle of the night.

Excessive short selling creates all kinds of problems for the targeted companies, and the market in general, when done in mass. This is why regulatory agencies have tried to moderate the practice (with things like up-tick rules) and some governments have even tried to ban the practice outright (as Germany did last spring when they found out short sellers were targeting some financial companies). But the best way to mitigate excessive short selling is not by creating artificial trading rules or subjecting the markets to arbitrary bans but by simply requiring the shareholder to give his or her approval before their shares are loaned to a third party. “Transparency” is the key. It naturally protects shareholder rights and puts an end to practices that harm ownership interests.

Another problem with companies that have high short positions is “over voting”. Short selling effectively creates more shares outstanding than shares authorised by the company and registered with the SEC. For example, if a company has 10 million shares authorised and outstanding, but shorts have borrowed and resold 2 million shares, there are now 12 million shares owned by accounts on the brokerage firm’s books. But when it comes time to send out proxies the company is only required to issue voting rights on 10 million shares (the amount on their books). However, the brokerage firm sees 12 million shares on its books and all of these shareholders must be given the right to vote. If it were not for widespread voter apathy (allowing the brokerage firm to give all its holders of record the right to vote but never collecting more votes than the company has authorised) there would be all sorts of legal ramifications – none of them good.

Bottom line, brokerage firms should not be allowed to loan “your” securities to someone without “your” knowledge and approval of what is going to happen to those securities. If you do decide to loan your shares to a short seller you should acknowledge the fact and be required to transfer the voting rights that go with those certificates. This type of disclosure and opt-in proxy approval would not only regulate short selling activity through natural means it would also eliminate any potential of over voting that now exists with companies that have high short positions.

The electronic back office has done wonders to speed the sale and transfer of securities, and that is good, but in the process it has inadvertently walked on shareholders rights. Shareholders deserve to know what is being done with their securities – especially if their shares are being used against their interests. With today’s technology such disclosures could be easily built into the securities clearing process.

When transparency is returned we will no longer have to wonder what our securities are doing tonight – and hopefully we all sleep a little bit better.